The remuneration operation

Madeleine Ross explores the disconnects between how clients want to compensate and how agencies want to be rewarded.

Talking money is awkward. Anyone with a mother born before 1960 would know it’s one of the three pillars of ‘inappropriate conversation’, alongside politics and religion.

But in agency land, discussing payment isn’t just awkward – it’s frustrating, fraught with misunderstanding and incredibly complex. So much so that Adland’s peak body, The Communications Council, declined to comment on the issue for this feature.

Agencies and clients have always come to blows over payment. Clients have always, and will always, want to minimise their costs and maximise the services they receive. But the pressure to create and implement campaigns cost-effectively has never been higher than it is right now.

In the bearish market of the last six years marketing budgets have been continually clipped and snipped, with CMOs depending more and more heavily on procurement to drive agency costs to the lowest-possible levels.

But, as agencies continually remind their clients, there’s no such thing as a free lunch.

David Gaines, managing partner at Edentify and former CEO of Maxus, recalls one of his agency compatriots describing fee structure to a client as follows: “We have three models: cheaper, faster, and effective. You can pick two of those.”

“He was bang on the money,” says Gaines. “Yes agencies can do cheaper and faster but no-one’s saying it’s going to work. Or they can do it fast and effective, but that is going to require lots of resources and time so it’s going to cost more.

“You can only have two of those, but increasingly agencies are being pushed to provide all three and then something snaps.”

According to Mat Baxter, CEO of UM, the single biggest issue facing agency remuneration is the chasm between agency remuneration and client results. All too often remuneration models and results have zero correlation.

There are currently three major payment models in the market. Cost-based (which accounts for the vast majority), commission-based, and output/outcome-based.

In the myriad of remuneration models in market, performance-based remuneration is, by consensus, the fairest way to compensate an agency. But putting this into action is no simple feat.

Remuneration models: Cost-based systems

At the heart of remuneration qualms between clients and agencies is a very simple clash of goals. While marketers are now under excessive pressure to drive productivity and efficiency, agencies are, in many ways, incentivised to do the opposite.

Cost-based remuneration models – which make up 93% of payment models in the US according to the Association of National Advertisers – don’t reward the agency based on their performance, but rather compensate them for hours worked and resources used, including retainers and project fees.

“The whole system has been reduced down to a cost system so it’s not about what value is created or delivered, it’s all about what it costs to deliver those services,” says Darren Woolley (left), founder of pitch consultancy TrinityP3.

“Everything is about head hours and salary costs and billable hours per year and how much you should mark up the overhead. It is all about cost, it’s not about what is actually produced.”

Agencies, as businesses, will always seek to drive up their own profits and if there’s no pot of gold at the end of the rainbow, a simple way to increase margins is to work longer hours and less efficiently. The model, by its nature, therefore encourages average work.

“You find most agencies are incentivised to spend smartly but not deliver efficiency and productivity gains back to a business,” says Andy Lark, outgoing CMO of the Commonwealth Bank. “Every single business is sitting there saying ‘we need to eek more out of our budget, we need to spend less or we need to fund more within the existing envelope’, but there is nothing really in most of the agreements and contracts which says ‘if you deliver savings back to the client there are benefits’. The threat of extinction is not a very good incentive.”

Nima Yassini (right), acutely aware of this flaw in the system, recently did away with the retainer model in setting up his creative agency, New Republique.

“Retainers are nothing more than financial structures for agency security,” he says. “They have nothing to do with quality of work and dedication to results. Regardless of results and quality of product, the agency gets paid. I think they breed complacency. Once you have a retainer the desire, hunger and need for survival is lost.”

Both parties – clients and agencies – have been complicit in this flawed arrangement. Clients seem to have been content in compensating for what they see as the essentials, and agencies, by charging for head hours, can guarantee they will recoup their costs.

According to Woolley, agency thinking goes that ‘if I can get my client to pay for the salaries plus the cost of operation and some profit, I am in front’. But then the agency can’t grow, except for acquiring new business.

But, what if I could grow my revenue by helping the client be more successful?

Remuneration models: Commissions

More on helping grow revenue via success to come.

The second system, and the one traditionally used by media agencies, is the commissions system. There’s a legacy of media agencies being remunerated based on client expenditure. The more agencies spend on media, the more they get paid.

This method is not as common as it once was, although Gaines notes that “the going in point” with any client is generally still a commission-based conversation; what percentage of the budget the client will get the service for, then there are layers of services on top of that, which the agency might charge for.

UM’s Baxter (left) is one of many agency heavyweights who believes that the commission system is archaic. “Advertising expenditure no longer has a linear relationship with the resource and efforts associated with managing business, particularly given the increasing complexity of the media marketplace,” says Baxter. “That is particularly true of smaller clients that are often more time-consuming to manage and require a depth of strategic skills from an agency to outsmart, rather than to outspend, their competition.”

In the US, only 7% of agency remuneration contracts are now commission-based.

Remuneration models: Value and performance-based

The third way of remunerating agencies is using a value-based model, which is increasingly hailed as the fairest and most sustainable by clients and agencies alike.

Within this camp there are, as TrinityP3’s Woolley defines, output-based value models and outcome based value models. The former focuses on the deliverable outputs required by the marketer and produced by the agency, stepping away from the cost-based model’s focus on resources and associated costs.

Here, the marketer sets a price for a project initially based on historical prices, strategic importance, the potential value to the business in terms of achieving objectives, and geographic use (whether it’s a major market, minor market or multiple market), instead of “interrogating” the cost of the service provided after the event.

Add to that a performance-based compensation component, and you get the outcome-based value model. Under this structure, agencies are rewarded according to how much they impact outcomes, including improving market share, contributing to sales or improving the marketing metrics, like propensity to buy or desirability.

“You start to pay the agency increasingly on their contribution to making those metrics move,” says Woolley.

The way this usually works is that agencies either receive bonuses on top of their base compensation and profit margin for achieving pre-agreed objectives, sacrifice a portion of their base compensation to receive a bonus higher than the profit margin for achieving a pre-agreed set of objectives, or earn their profit margin on achieving a pre-agreed set of objectives.

According to Woolley, these pre-agreed sets of objectives or metrics generally fall into one of three categories (see above).

UM’s Baxter says: “The most equitable arrangement will always be pay for performance. An agency takes on the risk of providing a team for a client and only gets paid based on the results they deliver.

“Of course, this sort of arrangement must appropriately compensate the agency for the true value of its performance, so if an agency can prove it generates an incremental sales of $100m it should get a decent slice of the pie, not a measly crumb. Conversely, if an agency delivers no tangible results then a client should pay nothing. This sort of arrangement demands a fundamental change in the way clients and agencies interact.”

Attitudes from clients are similarly positive. Sian Chadwick, APAC marketing director at American Express, describes pay for performance as “one of the best payment structures” she’s ever used. “Some of the most successful campaigns I’ve worked on have used this model,” Chadwick says. “When both a company and an agency have ‘skin in the game’ it acts as a motivating factor, which often produces better results”.

But Edentify’s Gaines is sceptical. “Very few clients would ever do that,” he insists.

Why? “Because if I am running a media agency and a client says ‘you get a share of that revenue’, I am going to say ‘I want decisions around distribution. I want that to be part of my remit because if I come up with an amazing campaign but it falls down because your sales guys don’t have their shit together with distribution, you can’t penalise me for that’. So it’s a very complex model. It would probably have to be based more around bonus.”

The impact of digital

According to Lark (below), “we are in the early stages of remuneration being up-ended by new media and digital media.” Digital now makes up around 40% of client spends, and is forcing clients and agencies to rethink benchmarks and metrics applied to traditional channels.

Owned media, for example, like building a website or an app, requires no purchase of media.

In the old days, 15% of a budget was commonly spent on production and agency fees, while 85% was spent on media. This doesn’t apply to digital because many of the projects are 100% production and implementation and no paid media at all.

There are also no associated fixed costs. Think of magazines or newspapers for instance. The cost of printing and distribution are hefty and are, to a large extent, recovered by selling ad space. Traditional media owners would generally allow 20% to 30% of the total cost of advertising as a rebate to agencies to help get the sale.

But a website, compared to a magazine, is relatively cheap, having to recoup neither of these costs. Because of this, media owners can afford to have in some cases 60% to 80% of the budget given back to the agency as a rebate. But many clients aren’t seeing that rebate passed on to them.

Temperatures have been running hot in media agency land amidst rumours that many agencies are favouring digital channels because they deliver bigger profit margins – margins which clients are not savvy about.

“There is a huge issue in this, especially around trading desks and demand side platforms,” says Woolley. “Everyone is asking for transparency but in a digital environment things are traded on a day-by-day basis because there is so much inventory.

“A lot of the media agencies are saying that when they build these trading desks they invest in the technology to find the right inventory and buy it at the best price. So rather than the client pay for that, agencies are saying they will take a margin and that will cover the use of the technology and still give you the best price in market.

“Now the clients are saying ‘we are not happy with that. We want to know exactly how much margin you’re making’.”

But digital isn’t all smoke and mirrors. Because digital is highly measurable, it is easy to prove causation when compared to other media, making it “the ultimate pay for performance channel”, according to UM’s Baxter.

“This means agencies can demonstrate their efforts have had a direct impact on a client’s business and can put a case to them to be remunerated accordingly,” he insists. “Digital is the saviour in the whole remuneration debate.”

AMEX’s Chadwick agrees: “Digital is a new frontier. One of the benefits of the digital world is the amount of available data that can be used to measure the success of a particular campaign. If used effectively, this data can bring greater transparency to the remuneration process, which ought to benefit all parties.”

New media, new attitude

The question on every client’s lips is: how should they remunerate agencies across new media platforms which don’t afford agencies and clients traditional compensation models?

New media giants like Facebook and Google don’t typically rebate media agencies for purchasing ad space or SEM, so increasingly there is a shift in remuneration taking place, from traditional media commission models to fee-based management models, where clients are paying their agencies for the work they do and the effectiveness of that work.

There’s a long way to go before partners have this relationship figured out though.

While purchasing digital display, or purchasing ad space on Facebook is simple, how should agencies be charging clients for social media, or for SEO?

“In the future there are going to be all sorts of new compensation models for agencies so they can benefit from striking and managing media sponsorship deals from helping create media,” says CBA’s Lark. “As more and more clients are aware of the potential of owned media and earned media over paid media, I think agencies have every right to start seeking compensation for the value they bring to those other channels.

“If consumers engage through a channel, agencies will be able to access reward there. And as there is more attribution of sales to those channels, so I think you will see people looking to share in the benefits.”

Off-shoring: threat or opportunity?

Creating digital inventory is time-consuming, labour-intensive and expensive. Clients, realising Australia’s proximity to the huge low-cost markets in Asia and India, are now pushing for the bulk of their digital production to be done overseas.

“We did it at Dell,” says Lark, former global marketing vice president at the computer giant. “We literally took hundreds of millions of dollars of cost out of our spend by migrating large tracks of our production to Bangladesh.”

On the face of it, this is a real threat to Australian agencies, who can’t possibly meet the prices. Increasingly, clients are detaching themselves from their agencies and going direct to these affordable markets.

“All of the big advertisers are looking at decouping from their agencies and going direct to cheaper markets for certain types of work,” says Woolley. “In the next two to five years, it will be a major thing for big advertisers to decouple their digital and production and move it offshore. Microsoft’s digital advertising is done out of India. Creative conceptual work is done in Western markets but it’s actually produced in India.”

But there is an alternative. Some agencies are now offering their clients blended rates to keep themselves in the game. This involves a client offering, for example, $80 per hour to a local agency for a job which would normally cost $200, with the understanding that the agency will pass on the job to an overseas supplier which charges approximately $20 an hour.

That way, the agency handles the leg work and is accountable for the execution’s quality – both of which make the client’s life easier.

Lark sees one bi-product of such a relationship as more power being divested in big global agency networks. WPP handled the transition of Dell’s digital work to Bangladesh – its reach and penetration instrumental in securing the best deals for the computer giant.

“If you are buying from an agency which is part of a global network, your face to the agency is local, but the back-end to the agency from finance to accounting, HR, to production, is offshore,” he says. “So the agencies are able to compete and be more profitable because of their network. It will be interesting to see how new agencies get born in this new world where those with a network have a definitive cost advantage.”

At the end of the day, you get what you pay for. “If you want the best agency on your business, you have to be willing to pay for them,” says Baxter.

As clients and agencies wise-up to the potential benefits of performance-based remuneration models, things can only get better.

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